Foreword

Eileen Claussen, President, Pew Center on Global Climate Change

Over the next century, global climate change is likely to have substantial consequences for the economy of the United States and the welfare of its citizens. As scientists work to narrow remaining uncertainties about the magnitude and timing of future warming, it is becoming increasingly important that we improve our understanding of the likely implications for human and natural systems.

In this report, a team of authors led by Dale Jorgenson of Harvard University developed an integrated assessment of the potential impacts of climate change on the U.S. market economy through the year 2100. The analysis combines information about likely climate impacts in specific market sectors with a sophisticated computable general equilibrium model of the U.S. economy to estimate effects on national measures of productivity, investment, consumption and leisure. To account for uncertainties— both in the trajectory of future climate change and in the ability of different sectors to adapt—a variety of scenarios were modeled to characterize a range of possible outcomes.

The results indicate that climate change could impose considerable, lasting costs or produce smaller, temporary benefits for the U.S. market economy in coming decades. Importantly, potential costs under pessimistic assumptions are larger and persist longer than potential benefits achieved under optimistic assumptions. Because of “threshold effects” in key sectors like agriculture, initial benefits from a moderate amount of warming begin to diminish and eventually reverse as temperatures continue to rise toward the end of the century and beyond. These findings suggest that near-term action to limit the pace and scale of future climate change would be warranted not only because the potential damages outweigh potential benefits (which are transient in any case), but because early intervention would reduce the long-term damage under either set of assumptions, and reduce the need for more costly measures if pessimistic scenarios materialize.

This study makes an important contribution to our current understanding of the potential impacts of climate change, but it represents at best a partial assessment of the full range of those impacts. Certain market sectors (e.g., tourism) and a variety of indirect effects (e.g., climate change induced healthcare expenditures) could not be included because of a lack of data. Even more significantly, the analysis does not account for critical non-market impacts such as changes in species distributions, reductions in biodiversity or loss of ecosystem goods and services. These types of effects are described in a companion Pew Center report—A Synthesis of Potential Impacts of Climate Change on the United States—but remain extremely difficult to value in economic terms. Their inclusion in a more complete evaluation of both market and non-market impacts would almost certainly offset any temporary market benefits and add to the negative impacts, thereby underscoring the case for mitigative action.

The Pew Center and the authors are grateful to Henry Jacoby and Billy Pizer for helpful comments on previous drafts of this report.

Executive Summary

The continued accumulation of heat-trapping gases in the atmosphere is projected to have far reaching consequences for earth’s climate in coming decades. For example, in 2001, the Intergovernmental Panel on Climate Change (IPCC) predicted that average global temperatures could rise anywhere from 1.4oC to 5.8oC (2.5-10.4oF) over the 21stcentury, with warming for the United States as much as 30 percent higher. Climatic shifts of this magnitude would affect human and natural systems in many ways. Therefore, quantifying these impacts and their likely costs remains a critical challenge in the formulation of appropriate policy responses.

This study aims to advance understanding of the potential consequences of global climate change by examining the overall effect on the U.S. economy of predicted impacts in key market activities that are likely to be particularly sensitive to future climate trends. These activities include crop agriculture and forestry, energy services related to heating and cooling, commercial water supply, and the protection of property and assets in coastal regions. Also considered are the effects on livestock and commercial fisheries and the costs related to increased storm, flood and hurricane activity. Finally, the analysis accounts for population-based changes in labor supply and consumer demand due to climate-induced mortality and morbidity. Impacts in each of these areas were modeled to estimate their aggregate effect on national measures of economic performance and welfare, including gross domestic product (GDP), consumption, investment, labor supply, capital stock and leisure.

At present, our knowledge of the direct or indirect impacts of climate change on a broad range of economic activities is incomplete. Accordingly, there are important sectors and activities—such as tourism—that are omitted from this effort. Similarly, there is little information concerning possible interactions among the benefits and costs in different sectors. For example, the impacts on crop and livestock agriculture may have consequences for human health. Given the absence of reliable insights into such externalities or spillovers, these effects are also excluded from consideration. These limitations suggest that the results of this analysis are likely to understate the potential market impacts of climate change.

More importantly, this analysis does not consider the non-market impacts of climate change such as changes in species distributions, reductions in biodiversity, or losses of ecosystem goods and services. These considerations are essential to a complete evaluation of the consequences of climate change but are very difficult to value in economic terms. A companion report, A Synthesis of Potential Impacts of Climate Change on the United States, provides more detail on the relative vulnerability of different U.S. regions to both the market and non-market impacts of climate change.

To capture the range of market consequences potentially associated with climate change in the United States and to address the considerable uncertainties that exist, several distinct scenarios were developed for this analysis. Each incorporates different assumptions about the magnitude of climate change over the next century and about the direction and extent of likely impacts in the market sectors analyzed. Specifically, three different levels of climate change (low, central and high) were considered in combination with two sets of market outcomes (optimistic and pessimistic) for a total of six primary scenarios. In terms of climate, the low, central and high scenarios encompass projected increases in average temperature ranging from 1.7oC to 5.3oC (3.1-9.5oF) by 2100, together with precipitation increases ranging from 2.1 to 6.6 percent and sea-level rise ranging from 17.2 to 98.9 cm (7-40 inches) over the same period. In terms of impacts, the optimistic and pessimistic scenarios reflect a spectrum of outcomes from the available literature concerning the sensitivity of each sector to climatic shifts and its ability to adapt. As one would expect, the optimistic scenarios generally project either smaller damages or greater benefits for a given amount of climate change compared to the pessimistic scenarios.

Because several of the market sectors included here are especially sensitive to changes in precipitation, two additional scenarios were analyzed. The first assumes the high degree of temperature change combined with lower precipitation (“high and drier”) while the second assumes the low level of temperature change combined with higher precipitation (“low and wetter”).

By introducing the sector-specific damages (or benefits) associated with each of these scenarios into a computable general equilibrium model that simulates the complex interactions of the U.S. economy as a whole, the combined effect of climate impacts across multiple sectors could be assessed in an integrated fashion. Detailed results are described in the body of this report, but five principal conclusions emerge:

1) Based on the market sectors and range of impacts considered for this analysis, projected climate change has the potential to impose considerable costs or produce temporary benefits for the U.S. economy over the 21st century, depending on the extent to which pessimistic or optimistic outcomes prevail. Under pessimistic assumptions, real U.S. GDP in the low climate change scenario is 0.6 percent lower in 2100 relative to a baseline that assumes no change in climate; in the high climate change scenario, the predicted reduction in real GDP is 1.9 percent. Under the additional “high and drier” climate scenario, however, real GDP is reduced more dramatically—by as much as 3.0 percent by 2100 relative to baseline conditions. Furthermore, under pessimistic assumptions negative impacts on GDP grow progressively larger over time, regardless of the climate scenario. In contrast, under optimistic assumptions real U.S. GDP by 2100 is 0.7 to 1.0 percent higher than baseline conditions across the low, central and high climate scenarios, but these benefits eventually diminish over time. Nevertheless, to the extent that responses in certain key sectors conform to the optimistic scenarios, there is a distinct possibility that some degree of climate change can provide modest overall benefits to the U.S. economy during the 21st century.

2) Due to threshold effects in certain key sectors, the economic benefits simulated for the 21st century under optimistic assumptions are not sustainable and economic damages are inevitable. In contrast to the pessimistic scenarios which show increasingly negative impacts on the economy as temperatures rise, the economic benefits associated with optimistic scenarios ultimately peak or reach a maximum. Specifically, the agriculture and energy sectors initially experience significant cost reductions, but only so long as climate change remains below critical levels. Once temperature and other key climate parameters reach certain thresholds, however, benefits peak and begin to decline—eventually becoming damages. Different thresholds apply in different sectors and the time required to reach them depends on the rate at which warming occurs. In the high climate change scenario, the trend toward economic benefits under optimistic assumptions slows and peaks around mid-century, whereas, in the central climate case, this transition appears toward century’s end. In the optimistic, low climate change scenario, benefits continue to accrue throughout the 21st century. Nevertheless, the existence of these thresholds means that continued climate change—even if it proceeds slowly—eventually reverses market outcomes so that predicted economic benefits are only transient and temporary.

3) The effects of climate change on U.S. agriculture dominate the other market impacts considered in this analysis. Currently, the agriculture, forestry and fisheries industries represent about 2.0 percent of total U.S. industrial output and about 3.5 percent of real GDP. However, agriculture accounts for a much larger share of the overall climate-related economic impact estimated in this analysis. For example, across the low, central and high climate change scenarios, field crop and forestry impacts account for over 70 percent of the total predicted effect of climate change on real GDP under optimistic assumptions and almost 80 percent of the total GDP effect under pessimistic assumptions. These figures rise to 75 and 85 percent, respectively, if one includes climate effects on livestock and commercial fisheries. Clearly, significant impacts in relatively small sectors can exert a disproportionate influence on the overall economic consequences of a given climate change.

4) For the economy, wetter is better. All else being equal, more precipitation is better for agriculture —and hence better for the economy—than less precipitation. Not surprisingly, reductions in precipitation are costlier at higher temperatures than at lower temperatures and the negative impacts of drier climate conditions are greater under pessimistic assumptions than they are under optimistic assumptions. These results are driven by model assumptions about the relationship between agricultural output and different levels of precipitation; they do not consider regional or seasonal variability nor do they account for possible changes in the incidence of extreme events such as drought and flooding. To date, variations in precipitation have not been routinely incorporated in assessments of the agricultural impacts of climate change; nevertheless, they are potentially quite important and could significantly affect actual benefits or damages associated with climate change in this sector of the economy. Therefore, in future assessments, more attention should be paid to the specific effects of precipitation under different climate scenarios.

5) Changes in human mortality and morbidity are small but important determinants of the modeled impacts of climate change for the U.S. economy as a whole. An increase in climate-induced mortality or illness reduces the population of workers and consumers available to participate in the market economy, in turn leading to a loss of real GDP. In this analysis, mortality and morbidity effects alone account for 13 to 16 percent of the aggregate predicted effect of climate change on the economic welfare of U.S. households. Failure to include such effects therefore understates the potential market impacts of climate change as well as the likely benefits of climate-mitigating policies. Furthermore, the economic consequences of the mortality and morbidity effects arising from a given change in temperature are at the low end of mortality valuations found in the reported literature. Hence, the contribution of health effects to the aggregate market impacts of climate change could be even higher than these results suggest.

Taken together, these findings have important implications for current policy debates and for ongoing efforts to further refine our understanding of the likely impacts of global climate change. From a policy standpoint their primary relevance lies in the extent to which they support (or diminish) the case for intervention to avoid or mitigate the impacts being evaluated. Specifically, does the analysis suggest that the likely consequences of future climate change will be sufficiently negative as to warrant near-term actions aimed at reducing greenhouse gas emissions? This question is all the more difficult to answer because the benefits of policy intervention tend to accrue slowly, over a long period of time, while the costs of mitigative action must be borne in the near term.

On the one hand, the results of this analysis clearly point to the possibility that climate change could produce measurable negative impacts on the U.S. economy within this century that might justify anticipatory policy responses. On the other hand, the fact that some of the scenarios analyzed produce positive, albeit temporary, benefits for the U.S. economy in the same timeframe might seem to weigh in favor of forgoing, or at least delaying, such actions.

A number of nuances in these results—together with several larger considerations related to limitations inherent in the study’s design—argue against the latter conclusion. Within the scope of this analysis, perhaps the most important point is the fact that most, if not all, potentially positive impacts of climate change under optimistic assumptions are likely to be transient and unsustainable over the long run in the face of steadily rising temperatures. If, on the other hand, pessimistic assumptions prove to be more correct, the economic impacts of climate change are not only immediately negative, but worsen steadily over time. Thus, the potential for temporary economic benefits must be balanced against the potential for immediate and lasting economic damages.

A second important point is that the modeling results reveal asymmetries in the magnitude of potential benefits versus potential damages. Specifically, the economic losses estimated under pessimistic assumptions are generally larger than the transient benefits gained under optimistic assumptions in all but the low climate change scenarios. Moreover, the asymmetry becomes more pronounced with rising temperatures as certain types of costs—such as those associated with extreme weather events—increasingly offset possible benefits to other sectors of the economy.

A further caution relates to the partial and incomplete nature of the analysis itself. This effort was limited from the outset to considering only market impacts of global climate change within the United States. As has already been noted, it was not possible to include all potentially climate-sensitive market sectors in the analysis; nor was it possible to account for all externalities or spillover effects. Moreover, the results of this analysis are not likely to be representative of other parts of the world, especially for those countries whose overall economic well-being is more closely tied to sectors like agriculture. For these countries, the potential damages associated with future climate change could be a much larger proportion of GDP than in the United States and the downside risks under pessimistic assumptions—especially in regions where climate change is likely to cause increasingly warmer and drier conditions—could be far more substantial.

Even more significant, in terms of drawing policy conclusions from these results, is the fact that the underlying analysis does not address a host of potential non-market impacts associated with climate change. These include shifts in species distribution, reductions in biodiversity, losses of ecosystem goods and services and changes in human and natural habitats. Such impacts—many of which are explored in other Pew Center reports—are probably of great concern to the public and could carry substantial weight in future policy deliberations. They are, however, extremely difficult to value in economic terms. To the extent that they have been assessed—even qualitatively—the results suggest that climate-related impacts on natural systems are far more likely, on the whole, to be negative rather than positive. As such they would tend to add to any negative market impacts associated with future climate change, while offsetting potential market benefits of the kind simulated in this study under optimistic assumptions.

In sum, the disparity in results between optimistic and pessimistic scenarios—and the likelihood that a consideration of non-market impacts would tend to exacerbate this disparity—highlights the continuing uncertainty associated with quantifying climate change impacts. The fact that the economic losses associated with pessimistic scenarios are both larger and more continuous than the transient benefits gained under optimistic scenarios would seem, by itself, to provide some support for cautionary action on climate change. In fact, such action—by slowing the pace and magnitude of temperature increases in the U.S. market consequences of global climate change coming decades—actually could forestall any damages or even improve the odds that optimistic rather than pessimistic outcomes prevail. If, on the other hand, worst-case scenarios appear more likely over time and ultimately justify more dramatic intervention, early efforts to achieve moderate near-term emissions reductions may help avoid the need for more costly measures later on. Meanwhile, high priority should be given to improving and integrating future assessments of market and non-market outcomes and to refining our understanding of the probabilities associated with varying degrees of climate change and the positive or negative responses that follow.

Foreword

Eileen Claussen, President, Pew Center on Global Climate Change

The U.S. economy has proven both resilient and adaptive over the past century. From the "bust" of the Great Depression to the current "boom" associated with information technology, the economy's ability to adapt stems largely from the substitution possibilities within it — that is, how businesses and households alter their behavior when a major economic change occurs.

Reducing greenhouse gases could alter future economic conditions, largely through increased energy prices. While these changes could be significant, the economy is rapidly becoming even more flexible and responsive as technology changes the way things are invented, produced, and distributed. Accordingly, the damages to the economy might be less. Yet, many economic models used in predicting the future costs of climate change policies do not adequately capture the economy's full range of substitution possibilities. A recent Pew Center report entitled, An Introduction to the Economics of Climate Change Policy, identified substitution assumptions as one of five key factors having the largest influence on modeling results. The other factors are: how baseline greenhouse gas (GHG) projections are measured; what policy regime is considered; how technological progress is represented; and whether GHG reduction benefits are included.

This analysis by Dale Jorgenson, Richard Goettle, Peter Wilcoxen and Mun Sing Ho explores the role of substitution in adapting to economic change. It begins with what is considered a "flexible" model (a top-down, computable general equilibrium model of the U.S. economy) and then constrains the flexibility parameters within this model to observe its new results. In essence, the authors use the same model to behave both "flexibly" and "inflexibly" in order to observe the effect of this pivotal assumption on model outcomes.

The most striking conclusion of this work is that the failure to depict the full range of historically-observed substitution possibilities (as many economic models do) can lead to as much as a doubling of the estimated costs of a climate change policy, an overestimate that is wholly attributable to this one pivotal assumption. This overestimation may be even more pronounced since the economy appears more flexible today than in the post-war period when these observations were made. Another interesting finding is that v a rying the flexibility households have in choosing to work more or fewer hours can be as important in predicting carbon prices and economic outcomes as the assumptions about flexibility in all of production. In summary, economic models of climate change must represent the full range of flexibility that is achievable or risk significant errors in estimating economic benefits and costs.

This paper would not have been possible without the comments and support from several individuals. The Pew Center and authors would like to thank Larry Goulder, Jeffrey Frankel, and Hadi Dowlatabadi for their thoughtful comments on early drafts of this report. Special thanks are due to Ev Ehrlich for serving as a consultant on this project, and to Judi Greenwald for her editorial assistance.

Executive Summary

The U.S. economy's reaction both to climate change itself and to the policies designed to avoid climate change depends largely upon the abilities of consumers and producers to adapt to these changes and move forw a rd under new conditions. In turn, these abilities depend on the ease with which consumers and producers can alter their purchasing behavior without sacrificing welfare, income, and production. This ease is reflected largely in the economy's "substitution possibilities" — the options available to con-sumers and producers to change what they buy and sell in response to changes in the prices of particular goods and services. If the cost of economic substitution is low, and the range of substitution possibilities is wide, then mitigation costs — the damages to welfare, income and production — are likely to be low and the burden on the economy is likely to be small. If the cost of substitution is high, and range of substitutability is narrow, then mitigation costs are likely to be high. The purpose of this paper is to examine the economy-wide impacts of reduced substitution opportunities when the economy must adjust to a constraint on carbon emissions.

This analysis uses an economic model that, compared to other models, depicts a relatively complete set of substitution possibilities for consumers and producers. Simulation results from the model portray the economy's response to an emissions reduction schedule that is implemented through a system of tradable emissions permits. The first model simulation used substitution possibilities that were estimated from historical data. Next, the authors systematically replaced key parameters (i.e., coefficients or multipliers of selected mathematical relationships embedded in the model) in a manner that drastically reduced the substitution possibilities of producers and consumers. Each of these simulations defined a different world or economy. The authors then simulated each economy's reaction to proportionally identical emissions constraints. In this manner, the model produced measures of the economic responsiveness both with and without flexibility and the analysis quantified the benefits and costs of substitution.

Three areas of substitution are most important to the overall economic reaction to climate change. These are:

flexibility in production, meaning the ability of firms to substitute labor, capital, or other materials for energy or each other when the price of energy rises;

flexibility in consumption, meaning the ability of households to change the mix of goods and services they buy in response to higher energy prices; and

flexibility between labor (and, hence, income and consumption) and leisure, as households allocate their scarce time between the two.

The principal conclusions emerging from this analysis are:

1. When allow able substitutions reflect the observed behavior of the past , constraining carbon emissions to around 70 percent of their projected base-case levels costs the economy about a one and one-quarter percent loss in real Gross Domestic Product (GDP) and a one-tenth of one percent loss in economic welfare. For perspective, at current levels, this loss in GDP corresponds to an annual loss in income of $430 per person living in the United States and the welfare loss is equivalent to a tax, payable today, of $3,175 per person.

2. Constraining carbon emissions is generally more costly when substitutability in consumption or production is restricted. Thus, flexibility within the economy significantly reduces the adverse impacts of climate change and climate change policies. Real GDP losses are slightly larger when consumption is less flexible, and are doubled when production is less flexible. Failing to account for the full range of substitution possibilities in consumption and production will lead to overestimation of the negative effects of climate change policy.

3. Just as "rigidity" magnifies economic costs, it can also magnify economic benefits under certain circumstances. For example, inflexibility in consumption or production is beneficial to economic performance when: (a) climate change policies lead to additional tax revenues, and (b) the tax policy for reusing these additional revenues is economically advantageous.

In fact, the benefit is magnified the more inflexibility is introduced (assuming a and b hold).

4. Differences among models' treatment of the substitutability between consumption and leisure are likely to be every bit as important in predicting emissions permit prices and economic outcomes as are the models' underlying details of technology, consumption, or production. The more inflexible households are with respect to their consumption-leisure tradeoff, the lower the costs of reducing emissions. Contrary to what occurs when substitution is constrained in production or consumption, rigidity in this instance appears beneficial. However, this rigidity can also prove harmful. The combination of an emissions constraint, inflexibility in consumption and production, and more favorable tax treatment leads to economic benefits (point 3 above). Add inflexibility in consumption and leisure, and the combination leads to economic costs. Rigidities in household choices between consumption and leisure substantially limit the observed economic outcomes from climate change policy: either the adverse impacts are smaller or the potential benefits never materialize.

This analysis is important not only because of its results, but also because it explores this topic in a detailed and systematic manner within a single methodology. It is among but a few efforts to fundamentally change the character of a model in developing a sensitivity analysis. The numerous and well-documented outcomes of other policy experiments have informed the policy process. There now are fewer surprises when a particular policy design is subjected to the scrutiny of a broad range of models. But the quest for understanding does not end here. A model's outcomes depend on interactions among the various components that govern its behavior, and thus analysts need to identify and examine these components in both isolation and combination. The intent of this exercise is to increase understanding of the nature and magnitude of the benefits and costs of substitution by exploring the key features of one particular model and the economy it can portray. The hope is that this exercise makes a modest contribution to the formulation of environmental and economic policies that are beneficially robust over the broadest possible range of economic circumstances.